2 Overview In this chapter we turn our attention to the firm. A firm is an organization that produces goods or services for sale. We will begin by characterizing the relationship between the firm s inputs and the quantity of outputs it produces. The production function describes the relationship between the quantity of inputs and the quantity of outputs that the firm produces. Basic characteristics of the production function has implications for the cost structure for the firm, which in turn has implications for the firm ultimate supply function. Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30 The Production Function The Short Run and the Long Run It is useful to categorize firms decisions into - Long-run decisions involves a time horizon long enough for a firm to vary all of its inputs - Short-run decisions involves any time horizon over which at least one of the firm s inputs cannot be varied To guide the firm over the next several years, manager must use the long-run view To determine what the firm should do next week, the short run view is best. Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30

3 The Production Function Production in the Short Run In the short-run, the firm s inputs can be divided into one of two categories 1 Fixed inputs - These are inputs whose quantity is constant for some period of time (regardless of how much output is produced). - Typically, fixed inputs will include land and machinery, though they can also include certain types of labor (due to contracts). 2 Variable inputs - These are inputs whose quantity the firm can vary, even in the short run. - Examples of variable inputs often include labor, energy, fuel, etc. When firms make short-run decisions, there is nothing they can do about their fixed inputs; i.e., they are stuck with whatever quantity they have. However, they can make choices about their variable inputs. Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30 Total Product The Production Function To fix ideas, suppose we have a firm whose only variable input is labor All other inputs (capital, land, raw materials, etc.) we will assume for now are fixed. Total product is the maximum quantity of output that can be produced from a given combination of inputs. The total product curve shows how the quantity of output depends on the quantity of variable input, for a given quantity of the fixed input. We would generally expect the total product curve to be increasing; i.e., as the quantity of the variable input increases, we would expect total output to increase. Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30

5 Marginal Product The Production Function Notice that the Total Product curve is always increasing in this case, but that it s slope is not the same throughout. - Initial the slope is increasing - but eventually it starts to flatten out. The slope of the Total Product Curve is the Marginal Product of labor. Formally, Change in Quantity of Output Marginal Product of Labor (MPL) = Change in Quantity of Labor = Q L Tells us the rise in output produced when one more worker is hired Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30 The Production Function Units of Labor Total Product Marginal Product Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30

6 The Production Function The Marginal Product Curve Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30 The Production Function Marginal Returns To Labor As more and more workers are hired, the MPL is at first increasing - This is known as increasing returns to labor - This is typically due to the returns to specialization - It can also arise due to minimum labor requirements for equipment. Eventually, however, the MPL starts to decline - This is known as diminishing returns to labor - This arises as the gains from specialization are exhausted and - The constraints caused by the fixed inputs start to bind This pattern of MPL (and for other inputs) is thought to hold for most industries. Consider the problem of a woodworking shop. Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30

7 Marginal Cost and Average Cost Production and Firm Costs Understanding the nature of a firm s production function is important in that it has implications for the firm s costs. In the short run, the firm s costs can be divided into two broad categories: 1 Total Fixed costs (TFC): These are costs that do not depend upon the quantity of output produced. - These costs are typically associated with fixed inputs. - Examples of fixed costs might be the rent paid for the firm s building or equipment rentals. 2 Total Variable costs (TVC): These are costs that depend on the quantity output produced. - As the name suggests, these are costs associated with the variable inputs. - In the case of John s Woodworking shop, the TVC = w L where w denotes the wage rate. Total Costs = TFC + TVC. Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30 Marginal Cost and Average Cost John s Cost Structure Suppose that John has a TFC of $5000 and pays a wage rate of $1200 per week Units of Total Total Fixed Total Variable Total Labor Output Cost (TFC) Costs (TVC) Costs (TC) 0 0 $5000 $0 $ $5000 $1200 $ $5000 $2400 $ $5000 $3600 $ $5000 $4800 $ $5000 $6000 $ $5000 $7200 $ $5000 $8400 $ $5000 $9600 $14600 Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30

8 The Cost Curves Marginal Cost and Average Cost Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30 Marginal Cost and Average Cost Marginal and Average Cost Curves While the breakdown of Total Cost into Total Fixed and Total Variable Costs is helpful, two other measures of cost will be even more useful: 1 Marginal Cost: Measures the additional cost of producing one more unit of a good or service. 2 Average Cost: Measures the average cost per unit of the good or service (i.e., the costs averaged over all of the output produced by the firm). Understanding the distinction between these two concepts will be key to finding the optimal level of production for the firm. We ll start with average cost Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30

10 Marginal Cost and Average Cost The Average Cost Curves Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30 Marginal Costs Marginal Cost and Average Cost Another way of looking at the firm s cost structure is to look at its Marginal Costs; i.e., how it s costs increase as output increases. Formally: MC = TC (4) Q If we look at John s Woodworking Shop we have Output Total Cost Q TC MC Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30

11 Marginal Cost and Average Cost Adding in the MC Curve Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30 Marginal Cost and Average Cost Patterns in the MC and AC Curves Notice that the MC curve is - Initially declining- this is due to increasing returns to labor - Eventually increasing- this is due to diminishing returns to labor The minimum-cost output, Q min, is the quantity at which the average total cost is lowest. - This is at the bottom of the ATC curve. - and occurs where ATC=MC At outputs less than Q min, ATC > MC and ATC is falling. At outputs greater than Q min, ATC < MC and ATC is rising. Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30

12 Short-Run versus Long-Run Costs Production Costs in the Long Run Up until now, we have been focussing on the short-run, with some of the firm s inputs held fixed. In the long run, costs behave differently Firm can adjust all of its inputs in any way it wants In the long run, there are no fixed inputs or fixed costs; i.e. all inputs and all costs are variable Firm must decide what combination of inputs to use in producing any level of output The firms goal is to earn the highest possible profit To do this, it must follow the least cost rule; i.e., to produce any given level of output the firm will choose the input mix with the lowest cost This yields a Long-Run Average Total Cost Curve; i.e., the relationship between the output and the ATC when fixed costs are chosen to minimize total cost for each level of output. Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30 Short-Run versus Long-Run Costs Consider John s Woodworking Shop Suppose that in our first production function, we assumed that John had only one set of tools (e.g., 1 table saw, 1 drill press, and 1 router table). We ll call this one unit of capital The tools (and the space to house his tools) constitute fixed costs for John in the short-run. In the long-run, John must decide whether or not he wants to expand his capital stock The trade-off is that additional capital will avoid worker congestion, but imposes a large fixed cost on the firm. At low levels of production, having just one set of tools is not a binding constraint and John would rather avoid the additional capital costs. At higher levels of production, additional capital will avoid congestion problems and the capital costs are spread out over more units of production. Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30

15 Returns to Scale Short-Run versus Long-Run Costs LRATC curves for industries usually exhibit three basic phases: 1 Increasing Returns to Scale: Output range with declining LRATC This is also known as economies of scale Economies of scale often arise due to the gains from specialization. The greatest opportunities for increased specialization occur when a firm is producing at a relatively low level of output Economies of scale can also arise due to minimum size requirements for certain types of equipment. 2 Constant Returns to Scale: Output range with constant LRATC Over some range of production, size may not matter and firms of the same size will be equally cost-effective. 3 Decreasing Returns to Scale: Output range with increasing LRATC This is also known as diseconomies of scale As output continues to increase, most firms will reach a point where bigness begins to cause problems This is true even in the long run, when the firm is free to increase its plant size as well as its workforce Diseconomies of scale are more likely at higher output levels Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30 Short-Run versus Long-Run Costs Herriges (ISU) Ch. 12 Behind the Supply Curve Fall / 30

Chapter 10 OUTPUT AND COSTS Decision Time Frames Topic: Short Run 1) The short run is a period of time in which A) the quantities of some resources the firm uses are fixed. B) the amount of output is fixed.

Name: Solutions Cosumnes River College Principles of Microeconomics Problem Set 6 Due Tuesday, March 24, 2015 Spring 2015 Prof. Dowell Instructions: Write the answers clearly and concisely on these sheets

Microeconomics Topic 6: Be able to explain and calculate average and marginal cost to make production decisions. Reference: Gregory Mankiw s Principles of Microeconomics, 2 nd edition, Chapter 13. Long-Run

CHAPTER SEVEN THE THEORY AND ESTIMATION OF COST The production decision has to be based not only on the capacity to produce (the production function) but also on the costs of production (the cost function).

Econ Dept, UMR Presents The Supply Side of the Market in Three Parts: I. An Introduction to Supply and Producer Surplus II. The Production Function III. Cost Functions Starring Supply Production Cost Producer

Long Run Cost Making Long-Run Production Decisions To make their long-run decisions: Firms look at costs of various inputs and the technologies available for combining these inputs. Then decide which combination

S171-S184_Krugman2e_PS_Ch12.qxp 9/16/08 9:22 PM Page S-171 Behind the Supply Curve: Inputs and Costs chapter: 12 1. Changes in the prices of key commodities can have a significant impact on a company s

ECON 103, 2008-2 ANSWERS TO HOME WORK ASSIGNMENTS Due the Week of June 9 Chapter 6 WRITE [4] Gomez runs a small pottery firm. He hires one helper at $12,000 per year, pays annual rent of $5,000 for his

Short-Run Production and Costs The purpose of this section is to discuss the underlying work of firms in the short-run the production of goods and services. Why is understanding production important to

C H A P T E R 7 The Cost of Production CHAPTER OUTLINE 7.1 Measuring Cost: Which Costs Matter? 7.2 Costs in the Short Run 7.3 Costs in the Long Run 7.4 Long-Run versus Short-Run Cost Curves 7.5 Production

Principles of Microeconomics, Quiz #5 Fall 2007 Name MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question on the accompanying scantron. 1) Perfect competition

MBA 640, Survey of Microeconomics, Quiz #4 Fall 2006 Name MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1) In the short run, A) there are no variable

Pre-Test Chapter 20 ed17 Multiple Choice Questions 1. In the above diagram it is assumed that: A. some costs are fixed and other costs are variable. B. all costs are variable. C. the law of diminishing

MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1) Firms that survive in the long run are usually those that A) remain small. B) strive for the largest

Chapter 12 The Costs of Produc4on Copyright 214 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. What will you learn

Learning Objectives After reading Chapter 8 and working the problems for Chapter 8 in the textbook and in this Student Workbook, you should be able to: Essential Concepts Understand the information given

Chapter 13 1. Joe runs a small boat factory. He can make ten boats per year and sell them for 25,000 each. It costs Joe 150,000 for the raw materials (fibreglass, wood, paint, and so on) to build the ten

9 COST OVERVIEW 1. Total fixed cost is the cost which does not vary with output. Total variable cost changes as output changes. Total cost is the sum of total fixed cost and total variable cost. 2. Explicit

HW #7: Solutions QUESTIONS FOR REVIEW 8. Assume the marginal cost of production is greater than the average variable cost. Can you determine whether the average variable cost is increasing or decreasing?

Please Read: Cost Analysis and Estimation Chapter 9 Economies of of Scale and Software Production Economies of of Scale and Scope in in Telecommunications Economies of of Scale in in Automobile Accessories

Name: Class: Date:. Multiple Choice Identify the letter of the choice that best completes the statement or answers the question. 1. A price floor on corn would have the effect of a. creating excess supply

MPP 801 Perfect Competition K. Wainwright Study Questions MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1) Refer to Figure 9-1. If the price a perfectly

ECON 3310 Homework #4 - Solutions 1: Suppose the following indicates how many units of output y you can produce per hour with different levels of labor input (given your current factory capacity): PART

CHAPTER 8 PROFIT MAXIMIZATION AND COMPETITIVE SUPPLY REVIEW QUESTIONS 1. Why would a firm that incurs losses choose to produce rather than shut down? Losses occur when revenues do not cover total costs.

University of Pacific-Economics 53 Lecture Notes #8B I. Output Decisions by Firms Now that we have examined firm costs in great detail, we can now turn to the question of how firms decide how much output

Eco 301 Name Test 2 8 November 2006 100 points. Please write all answers in ink. You may use pencil and a straight edge to draw graphs. Allocate your time efficiently. 1. A fast-food restaurant currently

TRUE OR FALSE STATEMENTS SHORT-RUN PRODUCTION 1. According to the law of diminishing returns, additional units of the labour input increase the total output at a constantly slower rate. 2. In the short-run

Chapter 7 The of Production Topics to be Discussed Measuring : Which s Matter? s in the Short Run & Long Run Production with Two s-- Introduction The production function measures the relationship between

ECON 600 Lecture 3: Profit Maximization I. The Concept of Profit Maximization Profit is defined as total revenue minus total cost. Π = TR TC (We use Π to stand for profit because we use P for something

CHAPTER 8 COSTS OF PRODUCTION Chapter in a Nutshell This chapter gives an in-depth look at the costs of production for firms, both in the short run and in the long run. Although production techniques may

Production and Cost CHAPTER12 CHAPTER CHECKLIST When you have completed your study of this chapter, you will be able to 1 Explain how economists measure a firm s cost of production and profit. 2 Explain

Agenda Productivity, Output, and Employment, Part 1 3-1 3-2 A production function shows how businesses transform factors of production into output of goods and services through the applications of technology.

Chapter 6 Competitive Markets After reading Chapter 6, COMPETITIVE MARKETS, you should be able to: List and explain the characteristics of Perfect Competition and Monopolistic Competition Explain why a

CHAPTER 8 PROFIT MAXIMIZATION AND COMPETITIVE SUPPLY TEACHING NOTES This chapter begins by explaining what we mean by a competitive market and why it makes sense to assume that firms try to maximize profit.

COST & BREAKEVEN ANALYSIS http://www.tutorialspoint.com/managerial_economics/cost_and_breakeven_analysis.htm Copyright tutorialspoint.com In managerial economics another area which is of great importance

Problems on Perfect Competition & Monopoly 1. True and False questions. Indicate whether each of the following statements is true or false and why. (a) In long-run equilibrium, every firm in a perfectly

Econ 100B: Macroeconomic Analysis Fall 2008 Problem Set #3 ANSWERS (Due September 15-16, 2008) A. On one side of a single sheet of paper: 1. Clearly and accurately draw and label a diagram of the Production

LECTURE 10: SINGLE INPUT COST FUNCTIONS ANSWERS AND SOLUTIONS True/False Questions False_ When a firm is using only one input, the cost function is simply the price of that input times how many units of

Econ Dept, UMR Presents Perfect Competition-- --A Model of Markets Starring The Perfectly Competitive Firm Profit Maximizing Decisions In the Short Run In the Long Run Featuring An Overview of Market Structures

Economics 101 Fall 2013 Answers to Homework 5 Due Tuesday, November 19, 2013 Directions: The homework will be collected in a box before the lecture. Please place your name, TA name and section number on

Chapter 8 Profit Maximization and Competitive Supply Teaching Notes This chapter begins by explaining what economists mean by a competitive market and why it makes sense to assume that firms try to maximize

The Cost of Production 1. Opportunity Costs 2. Economic Costs versus Accounting Costs 3. All Sorts of Different Kinds of Costs 4. Cost in the Short Run 5. Cost in the Long Run 6. Cost Minimization 7. The

COST THEORY Cost theory is related to production theory, they are often used together. However, the question is how much to produce, as opposed to which inputs to use. That is, assume that we use production

Chapter : Elasticity Elasticity of eman: It measures the responsiveness of quantity emane (or eman) with respect to changes in its own price (or income or the price of some other commoity). Why is Elasticity

Learning Objectives After reading Chapter 10 and working the problems for Chapter 10 in the textbook and in this Student Workbook, you should be able to: Specify and estimate a short-run production function

Principles of Microeconomics Fall 2007, Quiz #6 Name MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question on the accompanying scantron. 1) A monopoly is